Understanding Vat On Investment Management Fees: What's The Deal?

The vailability of VAT exemption on investment management fees depends on the nature of the fund being managed and the type of management services provided. While some fees, such as transactional fees, may be VAT-exempt, other charges like annual management fees are typically subject to VAT. The distinction lies in whether the fees are charged strictly on a transaction-by-transaction basis or as part of a periodic management fee. This complexity has led to ongoing discussions between HMRC and industry bodies, as well as court cases, to clarify the VAT treatment of investment management fees.

Portfolio management services that are taxable

The tax implications of portfolio management services are complex and vary across different jurisdictions. In this response, I will focus on the tax implications of portfolio management services in India and the United Kingdom.

India

In India, portfolio management services (PMS) are subject to various taxes, including capital gains tax and the Dividend Distribution Tax (DDT).

Capital Gains Tax

Capital gains tax is levied on profits from the sale of securities within a PMS portfolio. Short-term capital gains (STCG) arise when the holding period of an asset is less than one year, and are taxed at the applicable slab rate. Long-term capital gains (LTCG) occur when the holding period exceeds one year and are taxed at a specified rate with indexation benefits.

Dividend Distribution Tax (DDT)

The DDT is applicable to dividends received from PMS investments. This tax is levied on the income distributed to investors at a specified rate before the dividends are distributed to them.

Portfolio Management Fees

The deductibility of portfolio management fees depends on the composition of the portfolio and the type of income it yields. If the income is taxable under the head "income from other sources", expenses incurred wholly and exclusively for earning such income may be tax-deductible. However, for income in the form of dividends or income from mutual funds, only interest expenditure is deductible and is restricted to 20% of such income.

United Kingdom

In the United Kingdom, portfolio management services that do not fall under the exemption for the management of special investment funds (SIFs) are considered taxable supplies. Value-added tax (VAT) is due on the services of managers who manage the investment portfolios of individual clients.

Charges made by managers for their management services, including annual management charges and performance charges, carry VAT at the standard rate. However, dealing fees/commissions charged strictly on a transaction-by-transaction basis for executing trades in exempt securities may be VAT-exempt if certain conditions are met.

In summary, the tax implications of portfolio management services vary depending on the jurisdiction and the specific circumstances of the investment portfolio. It is important for investors to understand the tax treatment of PMS investments to make informed financial decisions.

VAT exemption for special investment funds

The VAT exemption for special investment funds (SIFs) is an important consideration for investment managers when determining their VAT liability. Article 135(1)(g) of the Principal VAT Directive exempts 'the management of special investment funds as defined by Member States'. This exemption aims to facilitate investment in securities for investors through investment undertakings.

In the UK, the following funds were previously defined as SIFs for the purposes of the exemption until 30 September 2008:

• Authorised unit trust schemes (AUTs)
• Open-ended investment companies (OEICs)
• Trust-based schemes (TBS)

However, the definition of SIFs has evolved over time. Following the ECJ judgment in JP Morgan Fleming Claverhouse Trust plc, the term 'special investment funds' can include closed-ended investment funds, such as investment trust companies (ITCs). This judgment also emphasised that Member States have the discretion to define 'special investment funds' while considering the purpose of the exemption and the principle of fiscal neutrality.

As a result of this judgment, the exemption was extended to create a level VAT playing field for all similar collective investment undertakings competing in the UK retail market. This includes both closed and open-ended collective investment undertakings, regardless of their establishment location. Authorised Contractual Funds (ACFs) were later added to the list of SIFs, effective 28 June 2013.

It's important to note that the CJEU has provided further clarity on the scope of SIFs. In Fiscale Eenheid X, the court concluded that collective investment vehicles investing in real estate could fall within the exemption if the Member State subjects them to specific state supervision. Additionally, the CJEU's decision in ATP Pension Services established that defined contribution occupational pension funds could be considered SIFs if the pension customers bear the investment risk.

The VAT exemption for SIFs is a complex area, and investment managers should carefully review their agreements with research providers to optimise their VAT position.

VAT treatment of Aladdin portfolio management platform

The Court of Justice of the European Union (CJEU) has ruled that fees paid for the use of the Aladdin portfolio management platform are subject to VAT in their entirety. This ruling was made in the case of BlackRock Investment Management v HMRC, where the CJEU found that the fees were taxable even when the platform was used to manage qualifying special investment funds (SIFs).

Aladdin, or Asset, Liability and Debt and Derivative Investment Network, is an electronic system built by BlackRock Solutions, the risk management division of the investment management corporation BlackRock, Inc. The platform provides information to portfolio managers on every aspect of the investment lifecycle, enabling them to make investment decisions and monitor regulatory compliance. It is used by asset managers, banks, financial institutions, pensions, corporations, insurers, and wealth managers.

The CJEU ruling found that the supply of Aladdin services needed to be viewed as a "single indivisible economic supply". This means that even when the platform is used to manage both SIFs and non-SIFs, the fees for the service are subject to VAT in full. The Court distinguished this case from Commission v Luxembourg, where the cost-sharing exemption from VAT was allowed because the legal wording of the Directive expressly facilitated a difference in VAT treatment. In the case of Aladdin, there is no facilitating language in Article 135(1)(g) to permit a differentiated treatment based on the use or recipient of the supply.

The VAT treatment of portfolio management services that do not fall into the exemption for the management of SIFs is that they are taxable supplies. VAT is due on the services of managers who manage the investment portfolios of individual clients, whether provided on a discretionary or advisory basis. Charges made by the manager for their management services, including annual management charges and performance charges, carry VAT at the standard rate. However, dealing fees/commissions that are charged on a transaction-by-transaction basis and are directly linked to the sale and purchase of an investment product may be VAT exempt.

VAT recovery for private equity funds

The UK's Value Added Tax (VAT) is a complex tax that requires careful consideration. VAT is a transaction-based tax, and the rules for recovering VAT on related costs can be tricky, leading to partial exemptions and additional complications.

In the case of Melford Capital General Partner Ltd, a UK private equity fund was found by the First-Tier Tribunal (FTT) to be entitled to full VAT recovery on its establishment and operational costs. This decision was based on the specific facts of the case, particularly the fund and asset structure. The fund was structured such that a UK manager was VAT-grouped with the UK general partner of a fund LP (VAT Group 1). Below this was an Isle of Man (IoM) holding company (Holdco) and several IoM property-holding special-purpose vehicles (SPVs). The IoM is considered part of the UK for VAT purposes, and the holding company and SPVs were VAT-grouped (VAT Group 2). The funding for IoM Holdco came partly from share subscriptions and partly from interest-free loans from Fund LP, which then funded the SPVs. The UK manager charged each recipient for the investment and administrative advisory services provided to the GP, acting on behalf of the fund, as well as to IoM Holdco and each of the SPVs.

VAT incurred by the GP on establishment costs was deemed irrecoverable as it related solely to investment activities, which HMRC deemed non-economic activities for VAT purposes. However, the FTT found that VAT incurred on both establishment and operational costs was recoverable in full. This was because VAT Grouping effectively created two entities from a VAT perspective, and VAT Group 1 did not engage in any separate "non-economic" investment activities. All its activities were economic because they involved providing services (investment and administrative advisory) for a fee. The FTT considered VAT Group 1 analogous to a holding company and, based on case law, ruled that it was entitled to full VAT recovery of its costs.

This decision contrasts with HMRC's long-held perspective on how private equity fund activities should be viewed for VAT purposes. It remains to be seen whether HMRC will appeal the decision, but the FTT's ruling is based on well-established VAT principles.

VAT treatment of fund management fees

The VAT treatment of fund management fees is a complex area and the specific treatment will depend on the nature of the fund being managed and the type of management services provided. Here is an overview of the VAT treatment of fund management fees:

• Management of Special Investment Funds (SIFs): VAT exemption applies to the management of SIFs. However, if the fund manager also manages non-SIF funds, the VAT treatment may become more complex, as seen in the BlackRock case.
• Portfolio Management Services: If portfolio management services are provided to individual clients, VAT is typically due on the fees charged by the manager. This includes annual management charges and performance charges. However, dealing fees/commissions charged on a transaction-by-transaction basis for executing trades in exempt securities may be VAT exempt if certain conditions are met.
• Discretionary vs Advisory Basis: When a manager acts on a discretionary basis, the client authorises the manager to invest funds on their behalf within agreed parameters. In contrast, an advisory basis requires the manager to refer back to the client before any investment transactions. Both types of services are subject to VAT at the standard rate.
• Research Fees: HMRC considers the provision of research by investment managers to be a standard-rated supply. However, there is ongoing discussion and litigation regarding the VAT treatment of research fees, particularly in the context of MiFID II.
• Software Platform Fees: In the BlackRock case, the Court of Justice of the European Union (CJEU) ruled that fees paid for the use of a software platform providing portfolio management services were subject to VAT in their entirety, regardless of whether the platform was used to manage SIFs or non-SIFs.
• Private Equity Funds: In the Melford Capital case, a UK private equity fund was found to be entitled to full VAT recovery on its establishment and operational costs due to the specific structure of the fund and its assets. This decision presents opportunities for other private equity funds to review their VAT recovery positions.
• Brexit Implications: Following Brexit, VAT-exempt supplies of financial services to customers outside the UK may give UK suppliers the right to input VAT recovery, which was previously only available for customers outside the EU. This could benefit UK-based funds and fund managers in certain transactions.

The treatment of fund management fees is an evolving area, with ongoing discussions and reviews by HMRC and the European Commission. Investment managers should stay updated with the latest developments and consult professionals to ensure compliance with VAT regulations.

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